Wounded Rockets

Finding growth at value prices

2. GREEN

DELL, MICROSOFT, HOME DEPOT, CISCO, SUN. These are the classic growth stocks of our time. There's no such thing as a classic value stock. The whole point of a value stock is to buy it before it's no longer a value. In a field packed with lies and hyperbole, perhaps the single most ridiculous cliché is when an investor--usually a mutual-fund manager--says he looks for "growth at a reasonable price." As opposed to what, exactly? A pricey company with no room to grow?

Everyone wants to buy growth at a low price, and when that happens, the price doesn't stay low for long. The fact is, most fund managers will pay whatever they must to ensure they're holding impressive-sounding growth stocks in their portfolios.

Boiled down, growth investing means buying stocks in companies that are quickly growing revenues, and perhaps earnings, without regard to what you pay for that growth. The assumption is that there will always be someone stupider than you--aka the greater fool--to pay more for your company than you paid. Value investing means identifying stocks that trade below market levels based on fundamentals like PE ratio and book value.

These two approaches appeal to two completely different people. Warren Buffett, the greatest value investor of them all, isn't going to start buying tech stocks no matter what. They're too expensive, and if the oracle of Delphi appeared and told the Oracle of Omaha that he could score on a tech stock, Buffett still wouldn't buy. It's just not in him to pay $100 for a buck of earnings, even if he was guaranteed to sell that same buck for $150 next year.

And the kick-ass growth investor wouldn't be caught dead poring over balance sheets to see where he can buy a buck for fifty cents. To Mr. Vegas Growth Guy, value equals small-time. The value investor is smarter, more patient, the sharper analyst, and probably the better person. And he's also gone broke the last few years while the growth baboon ate his lunch.

In 1999, large growth stocks did 33.16 percent, and they were up 7.13 percent through this year's Q1, while large value stocks did 7.35 percent in 1999 and were barely above water through Q1 at 0.48 percent. If you read those numbers and conclude, "Well, I guess I ought to be exclusively in growth stocks," you probably always bet the favorite at the track. But if you're like me and you believe there's value in loving the underdog, then the secret is to find the few exceptions that actually do provide "growth at a reasonable price."

Everyone gets that a value stock is cheap. You'd expect a low PE ratio and a relatively high book value. The thorniest part of value investing is separating the companies that deserve to be cheap from those that are "accidentally" cheap--and will quickly be restored to where they "belong" by a forgiving community of investors.

In my opinion, the best way to unearth growth companies at value prices is identifying cheap companies that are already:

acquainted with growth habits,

led by those who've known the heights of in-favor stocks,

followed by investors who already associate their name with growth.

In other words, companies that used to be growth stocks but fell from grace. That strategy would have made investors in Merrill Lynch and Citigroup a lot of money when their long growth spurts temporarily tumbled into value range. But you've got to be careful: The same logic would have proven quite painful for investors who picked up Philip Morris or Oxford Health, two other great growth companies that fell into value range--and have stayed there.

This month, I bought two great growth companies that are coming off extremely rough years. Neither is even close to the mythical "classic value play," but each shows signs of cheapness. And, of course, both are led by guys who've been in the end zone enough to act as if they belong there.

I bought Disney because even though its PE is admittedly high--about 80 when I bought it--I'm getting a buck of sales for about $2.25, which is less than half the industry average. Disney's PS--my favorite measure for companies that generate large cash flows, like entertainment giants--is lower than News Corp.'s and way lower than Time Warner's and Viacom's. The future? Well, I'm not going to pretend to be able to judge the future of a business as complex as Disney any better than the analysts who got it wrong when the company lost half its value in 1999. (Count Buffett as a big Disney investor, too.) But Disney's five-year return on assets averaged 5.1 percent versus an industry average of 2.6 percent. (Time Warner was 0.1 percent, News Corp. 3.4 percent, and Viacom 1.5 percent.) As with a mutual fund, past performance means only so much for the future, but I like a manager with a track record.

I bought Nike because it's not just relatively cheap, but cheap--a PE of less than 18. Yes, the athletic-shoe business is in trouble, and, yes, its problems go deeper than the fact that Michael Jordan retired. But many wounded rockets are wounded only because of quick-trigger selling by growth investors with attention spans that Ritalin couldn't help. Nike's return on assets over the last five years averaged 11.5 percent (versus the industry average of 7.3 percent). Do investors really think Phil Knight suddenly forgot how to make money? Apparently so, but I'm betting they're wrong.

Maybe Warren and I aren't quite as alone as I thought. Janus just started its first-ever value fund, pulling in a staggering $1.5 billion before it even opened.

The Playbook

This is a model portfolio. I didn't actually make these trades. Since I am buying time-sensitive instruments, I don't want to deal with the hint that I stand to gain from these investments. But I'm reporting these moves to my editors as I make them, so the performance simulates real-world experience. The portfolio is for instructional purposes only. You can reach me at kenk@greenmagazine.com.

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